Common Factors in Financial Misreporting

Transcription

1 Common Factors in Financial Misreporting SPECIAL GUEST Daniel Bens Associate Dean, MBA programs & Associate Professor, Accounting University of Arizona JANUARY 31, 2012

2 GOVERNANCE, RISK & COMPLIANCE Policy & Procedures Risk Management Audit & Assurance Reporting & Analytics Strategy, Performance & Objectives Compliance Management Event & Case Management Control, Monitoring & Enforcement EthicsPoint focus areas

3 ETHICSPOINT SOLUTIONS ENABLE CLIENTS TO: COLLECT MANAGE LEARN risk data from multiple sources reports and case information in a unified system from risk-related data; monitor program effectiveness

4 ETHICSPOINT SOLUTIONS ENABLE CLIENTS TO: ACT Achieve business objectives Protect your brand Make better decisions Build strong cultures Manage organizational risk Optimize economic & social value Increase stakeholder confidence

5 OBSERVATIONS OF HISTORICAL REPORTING INITIATIVES Facilities Internal Audit Human Resources Legal Corporate Compliance Info Technology Risk Managemen t Operations Health & Safety

6 FRAGMENTED OVERSIGHT Facilities Internal Audit Human Resources Legal Corporate Compliance Info Technology Risk Risk Corporate Management Managemen Compliance t Legal Internal Audit Operations HR Corporate Security Health Information & Safety Technology

7 RISK DATA BEING LOST OR SILOED 50% 100% 30% 20% Observed Unreported and lost Siloed or trapped Actual risk being addressed SOURCE: COMPLIANCE AND ETHICS LEADERSHIP COUNCIL

8 8 Education Ph.D. (Accounting) from Wharton (1999) MBA (Finance) from Indiana (1995) BS (Accounting) from Penn State (1990) Experience : CPA at PwC & Westinghouse : faculty at University of Chicago, Booth School of Business 2005-present: faculty at University of Arizona, Eller College 2009-present: Associate Dean & Director, MBA Programs Teaching MBA students, introductory and advanced financial accounting Ph.D. students, empirical research methodologies Research Voluntary disclosure, causes and effects Financial accounting impact on managerial decision making About the Presenter: Daniel Bens

9 9 Research Question Do managers alter their financial reporting strategy in the face of investment-related pressure? Understanding the answer to this question allows corporate stakeholders to identify situations where the firm may be at risk for overly aggressive accounting choices by management. Can signal to shareholders/boards to increase vigilance Can signal to accountants/auditors to step up monitoring

10 10 Earnings Management We know that managers, at times, mis-state earnings for private gain (evidence is observed both anecdotally and in academic research) Yet we also know that legal and reputational penalties are significant to deter the behavior Further, the accounting system itself tends to reveal any frauds in due course: accruals will reverse when cash flow does not appear

11 11 Earnings Management When earnings management does occur, what causes it in the first place? Stock market pressure might induce some of this behavior, but again, overstated accruals can unwind quickly Outsiders may not see all of the private contracts that the firm has that might be tied to earnings, which can provide incentives to cheat Employment/compensation contracts Regulatory contracts Debt covenants

12 12 Earnings Management Research is consistent in that when companies are at or near thresholds on the income statement or balance sheet that affect firm/manager wealth via contracts earnings management is more likely Research is much more mixed about the pressure provided by stock market pressure, even when the company executives are heavily laden with equity incentives in their pay

13 POLLING QUESTION How likely do you find that the pressure to achieve accounting targets includes managers to aggressively report earnings upwards?

14 14 Earnings Management Classic example of contracts that induced earnings management: Bausch & Lomb in the early 1990s External competitive pressures coupled with internal sales incentive pressures led firm to stuff the channel by forcing distributors to purchase excess inventory Trend was clear: sales increase, but ballooning receivables and cash flow that diverges from earnings Yet outsiders could not observe the pressure that sales force was under and their response to distributors This relates to our project, which is to try to identify a force that might put the firm at risk

15 15 Earnings Management

16 16 M&A Related Pressure Corporate acquisitions are one of the most significant decisions that managers will have to make Stock market gives instant assessment of the merits of the deal Lehn and Zhao (2006 Journal of Finance): probability of CEO turnover goes up following a poorly received acquisition Example: Quaker Oats stock experiences a -10% return when Snapple acquisition announced CEO fired within three years Avg. stock return at announcement for turnover sample: -2.27% Avg. stock return at announcement for non-turnover sample: -0.38% Correlation is also assessed in a regression framework with controls

17 17 Summary and Our Prediction Earnings management exists, but difficult to say for sure when it might occur CEOs making acquisitions that the stock market judges as poor deals face pressure to perform We examine whether earnings management is used to relieve this pressure, even if it only benefits management in the short run

18 18 Example: Rite Aid s acquisition of Thrifty PayLess Deal is announced on 10/14/1996 Stock return over the next two days: -6.6% Earnings are managed upward over the next three years using the following techniques, among others: Overstatement of vendor allowances to reduce COGS Capitalizing repairs and maintenance instead of expensing Shifting expenses to future periods when benefits currently consumed Manipulation of restructuring charges

19 19 Example: Rite Aid s acquisition of Thrifty PayLess

20 20 Sample M&As announced between 1996 and 2007 per the SDC database Acquirer is a US public company Acquirer has information on Compustat and CRSP Deal value disclosed in SDC is at least 5% of the acquirer s market capitalization Total number of observations = 2,293 deals Restatements from Audit Analytics Exclude restatements related to adoption of new accounting standards or methods, mergers, stock splits Exclude observations coded by Audit Analytics as clerical errors

21 21 Timeline

22 22 Later Years of Sample (post-2005)

23 23 Univariate Analysis: Table 3

24 POLLING QUESTION If earnings management does occur, do you believe those responsible are aware that accounting manipulations will have to reverse themselves in the future?

25 25 Model for Multivariate Analysis RESTATE = a 0 + a 1 *CAR_MA + a 2 *SIZEMV + a 3 *ROA + a 4 *BTM +a 5 *LEV + a 6 *STD_RET + a 7 *TARG_PUB + a 8 *TARG_DOM + a 9 *STOCK_MA + a 10 *DIVERS_MA + a 11 *DEAL_SIZE + a 12 *ICD + TIME_F_EFFECTS + IND_F_EFFECTS + ε Main variable of interest CAR_MA= the three-day cumulative abnormal return around the M&A announcement Expect a 1 < 0 Control for acquirer s characteristics and deal characteristics

26 26 Multivariate Analysis: Table 4

27 27 Economic Interpretation of Analyses Univariate analysis For the 25% of the sample with the lowest M&A announcement stock returns, the percentage with future accounting restatements is 18% For the remaining 75% of the sample, the percentage with future accounting restatements is 11-12% Multivariate analysis For entire sample, the probability of a future restatement is 13% Probability increases to 15% for a one standard deviation decrease in M&A announcement returns, after controlling for other determinants of restatements

28 28 Multivariate Analysis of Post-M&A Turnover The effect of post-m&a misreporting on CEO turnover following an unfavorably received M&A event.

29 29 Economic Interpretation of Turnover Analysis For the firms with lower M&A announcement returns, the probability of CEO turnover in the year following the announcement is significantly greater than zero (the negative CAR_MA) Yet this relationship goes away for the firm that manipulated the accounting numbers (the positive CAR_MA * RESTATE) Implication: the manipulation actually buys the manager some time until it is found out, which then ratchets up the probability of being fired

30 30 Summary of Project For firms with more negative M&A announcement returns, managers attempt to buy time by misstating financial statements (and issue management forecasts that are optimistic this is in the paper, not addressed today) Pressure leads to financial misreporting, even in a setting where the costs of biased reporting are high (i.e., likely to be fired when found out)

31 31 Takeaways for Managers There is no silver bullet to identify likely accounting manipulations Research has found that contracts tied explicitly to earnings or the balance sheet can induce earnings management Pressure from the stock market is much more intangible, but most would agree it has some effect on accounting choices We provide evidence that negative returns around significant corporate investments provide a signal to be on alert for aggressive reporting We encourage managers/compliance personnel to look for not only that signal, but other forms of pressure

32 32 ANY QUESTIONS

33 33 Contact Information Questions? Please contact Daniel Bens at: Address: Daniel A. Bens 210 McClelland Hall University of Arizona Tucson, AZ Web: